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S&P rebalanced its style indexes in December, and the shuffle caused substantial turnover. The Value index now includes a sizeable swath of mega-cap tech companies, and this changing membership significantly affects the relative valuation metrics that defined those styles.

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Style investors recently witnessed a rare event when, on February 13^th, the P/E ratio of the S&P 500 Growth Index fell below that of the S&P 500 Value Index. At first glance, it is tempting to attribute this valuation flip-flop to the 2022 bear market, which saw Value outperform Growth by a whopping 24.2%. However, the bear-induced collapse of Growth stock prices in 2022 only served to return the P/E spread to a level just below its historical median of 5.1, meaning that the final move toward parity was caused by a force outside the market itself. That “something else” was the S&P 500 style reconstitution that occurs annually on the third Friday of December.

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One of the societal benefits of recessions and bear markets is that they serve to correct the unhealthy excesses that build up in overheated economic booms and overly enthusiastic bull markets. As market historians, we believe it is instructive to look back at cycles of excesses and their corrections to learn how such patterns evolve and, quite often, repeat themselves.

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The fourth quarter of 2022 saw broadly positive equity-market performance with the S&P 500 returning +7.6%, the Russell 1000 Mid Cap Index at +7.2%, and the Russell 2000 Small Cap Index gaining 6.2%. Strong returns usually present a headwind for active managers, but the fourth quarter proved productive for actively managed funds.

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Deflating valuations in the Technology and Innovation space produced ghastly results for growth investors in 2022, with the S&P 500 Growth index experiencing an agonizing 29.4% loss. Meanwhile, last year’s bear market was no more than a mild irritation for value investors as the S&P 500 Value index lost just 5.2%. The collapse in exuberantly priced growth stocks produced a 24.2% return spread between the value and growth styles, which goes into the record books as the second biggest annual win for value since 1975.

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Style rotation powered S&P 500 Value to a 24.2% advantage vs. Growth, while DM large-cap Value earned a 20% return spread against Growth. Small-cap spreads favoring Value were also in the double-digits, but narrower because small-cap Growth wasn’t exposed to the collapse of mega-cap Tech. 

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The 2022 bear market will be remembered as a year when collapsing growth stock valuations and rising interest rates doomed almost every asset class to return purgatory. Hopes for avoiding a second down year rest with a potential top in interest rates and solid earnings underpinning the stock market. Wall Street strategists have a year-end 2023 price target of just over 4,000 for the S&P 500, a few percentage points of upside from today but hardly reason to toast a prosperous new year.

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This earnings season has not been free of concern, and profit margins are clearly weakening from last year’s highs. Our earnings waterfall template highlights several themes coming out of third quarter results.

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A new study looking at the relationship between inflation and profit margins is introduced. The goal is to understand how the latest margin peak was reached in mid-2021 and what impact inflation might have on margin forecasts underlying next year’s earnings estimates. Full report will be sent mid-month.

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The 2022 bear market has been driven by collapsing valuation multiples, particularly for expensive growth stocks and unprofitable companies. Coming into the year, U.S. stocks stood as one of the most egregiously valued equity markets around the world, motivating investors to look elsewhere for more reasonably priced alternatives. Fortunately, international stock markets offered much better valuations that could serve as havens from the coming U.S. valuation collapse. Unfortunately, the strategy of seeking refuge in moderately priced foreign markets was foiled by an unusually strong U.S. dollar, leading us to take a closer look at how moves in the USD affect investment outcomes for domestic investors.

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The U.S. Dollar Index (DXY) has gained 16.2% YTD, its best performance in almost 40 years. However, a strong dollar is bad for those with international investments, as returns are slashed when translated back into dollars. 

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The balanced portfolio strategy of allocating 60% to equities and 40% to fixed income generated a highly satisfactory 7.9% annualized return over the last 30 years. Despite the excellent returns earned by investors following this strategic model, the past couple of years have seen a parade of articles with headlines such as “Is the 60/40 Portfolio Obsolete?” and “Is the 60/40 Dead?” Given the central importance of this moderate allocation strategy to investment industry practices, we felt a closer look at the 60/40 portfolio was in order.

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The 60/40 strategy is having a terrible year, and its failure to protect investors in the bear market prompted us to take a look at the history and theory of the 60/40 guideline. We offer an early preview of the study, with a focus on 2022’s abysmal year-to-date returns.

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Equity factors are characteristics that have historically generated excess returns relative to the universe of stocks. However, in recent years factor returns have been underwhelming, causing investors to wonder if factors have become too popular, too crowded, or just plain obsolete. Then came the second quarter of 2022, when all six major factors outperformed the S&P 500, a feat only accomplished in four quarters over the last 27 years!

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In Q2, all six major style factors outperformed the market. Those results are especially remarkable considering that factor excess returns the past few years have been underwhelming to the point that some investors began to wonder if they still work.

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The performance derby between actively-managed portfolios and passively-managed index funds is a topic of ongoing interest for Leuthold clients and the investment community at large. Therefore, we are providing an update to all charts and tables of our Active/Passive performance analyses.

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To paraphrase that great market historian Leo Tolstoy, “each bear market is unhappy in its own way.” Recession, interest rates, valuation bubbles, inflation, war, credit cycles, oil prices, manias & panics: the tipping point that triggers each bear market is always different. However, bearish forces ultimately manifest themselves in just two ways; declining earnings and/or declining valuations. June’s Of Special Interest report detailed how the current bear market has been fueled entirely by collapsing valuations, with the largest P/E compressions occurring in companies with the highest starting valuations.

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The 2022 bear market has been driven entirely by a collapse in P/E ratios. Last month, we noted that the other potential driver of market declines—falling earnings—had yet to raise its ugly head. Now we examine past episodes to consider how the stock market might react when the “other shoe” (EPS) drops.

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The most brutal bear markets occur when falling earnings are accompanied by shrinking valuations, producing a compound negative effect on stock prices. Investors in 2022 have (so far) avoided this double-whammy in that valuations have taken a hit, but EPS estimates are holding strong. We are intrigued by the notion that 2022’s bear market has, to date, been all about valuation compression rather than earnings weakness. Investors are coping with the problems of the day by letting the air out of bubbly valuations, and this report takes a closer look at the valuation squeeze underlying the current selloff.

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Stock market corrections are the result of falling valuations and/or falling earnings, and when both conditions appear together, investors are in for a rough ride. Thus far, the 2022 selloff has been confined to compressing P/E ratios, and we launched a research project to take a closer look at shrinking stock valuations in this market downdraft.

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